Spring 2023 Market Update

Special Update – What happened to Silicon Valley Bank (SVB)?

In its most simplified form, a bank’s activities traditionally boil down to taking deposits (a short-term liability for the bank) and making loans (a long-term asset). To ensure its sustainability, the financial institution must therefore ensure that it maintains sufficient high-quality liquid assets to meet bank withdrawal demands, at all times.

Next, one needs to take into account the peculiarity of the current environment – which is the speed and magnitude with which the U.S. Federal Reserve (the Fed) has raised interest rates over the past year. This created two important challenges for banks in general. First, it put downward pressure on bank deposits. Alternative investments with attractive risk-free returns (e.g. – high interest savings accounts), are far better alternatives than keeping your savings in a bank account. Second, as with all investors, the market value of bonds held by banks has declined significantly since the start of the rate hike cycle.

In SVB’s case specifically, the significant concentration of its clients within the technology sector, flush with cash in 2020-2021 (much less so now), was issue #1. Furthermore, their balance sheet was significantly overexposed to long-term bonds which quickly became an issue, as they now traded at a significant discount. Faced with a mismatch between its assets and liabilities, SVB attempted to raise new capital in early March, which instead highlighted the fragility of its financial position. This caused its depositors to request their cash and its shareholders to hit the “sell” button.

Many market participants would be quick to compare this bank failure to the 2008 Financial recession. However, 15 years later, the situation differs in several fundamental ways, including two in particular. First, the speed at which government agencies intervened. By last Friday, just three days since SVB’s demise, the Federal Deposit Insurance Corporation (FDIC) took control of the bank. By Sunday evening, the Fed, the FDIC and the U.S. Treasury announced that all (above the usual 250k) bank deposits would be covered. In addition, the Fed set up a loan facility that allows other potential troubled banks to borrow against the face value (par) of the bonds they hold rather than being forced to sell them at heavy losses in the markets. This type of response from the federal authorities was missing back in the financial recession of 2008/2009.

Secondly, the banking sector has much better capitalization than it did 15 years ago.  Overall, today’s banking regulations impose a much more conservative balance sheet requirement.  The largest banks typically hold 10-12% of cash on their balance sheets to ensure there is no shortage of liquidity.  Arguably, these regulations will be scrutinized even further for the smaller regional banks, given the recent developments.

MARKET UPDATE – GOOD NEWS IS BAD NEWS

After an optimistic start to the year in January, investor sentiment deteriorated slightly in February. The optimism for slowing interest rate hikes was short-lived when the U.S. Federal Reserve (the Fed) raised its benchmark rate by 0.25% to 4.75%, on February 1st. Although the rate hike was not really a surprise, the rhetoric around the rate hike caused for markets to be concerned. The U.S. Non-farm Payroll Report showed that employment rose by 517,000 jobs, in January. Consequently, the unemployment rate was unchanged at 3.4%, and held steady since early last year. The strong jobs market suggested that higher interest rates had not sufficiently slowed the economy. In turn, the markets started to price in further action from the Fed.

On March 8th, the Bank of Canada held its overnight target rate steady at 4.5%. This was the first time the Canadian central bank paused since January 2022. After 8 consecutive interest rate increases, we started to see a divergence in interest rate policy between Canada and the U.S. Unfortunately, the impact of the Bank of Canada’s decision was overwhelmed by the U.S. Fed Chair, Jerome Powell’s testimony to Congress. He stated, “the latest economic data has come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated”. This reiterated the direction of the current interest rate policy in the U.S. and caused for most major markets to give back some of the gains from January. More importantly, the stark frankness of the comments confirmed the Fed’s prioritization of inflation reduction over recession avoidance. The Feds will announce their next rate decision later this month (March 22nd). With the latest developments in the U.S. banking sector, there has been a shift in consensus as to whether they will raise rates or now possibly pause with a hawkish tone for further rate hikes.

In Canada, inflation continues to run far above its target. The interest rate increases to-date may have tempered inflation’s climb, but they have not brought price increases back into the target range of 2%. However, the Canadian economy is deemed to be more fragile than the U.S. as the consumer is more impacted by rate changes. This is primarily due to our mortgage regulations in Canada. Most Canadian mortgages are 5-year terms and therefore more homeowners will need to renew their mortgages at higher interest rates. Whereas, the U.S. consumer has the privilege of 30-year mortgages and therefore the U.S. housing market is less sensitive to changes in interest rates, in the near term.

All this put together causes for a cautious approach to the equity markets. However, this also implies increasingly attractive risk/return levels for the bond markets relative to equities, with a focus on high quality bonds in particular.

Although the optimism in January was a breath of fresh air for investment portfolios, February/March has reminded us that we may be still be in the early innings of a mild recession and therefore applying caution to the markets would be prudent.

FOOD FOR THOUGHT

Mr. Warren Buffett published his Letter to Shareholders a few weeks ago (Read Warren Buffett’s annual letter to Berkshire Hathaway shareholders (cnbc.com). His opening remarks were a great read as always. However, a couple of comments stood out for me. He referenced his long-time business partner, Charlie Munger, and cited a few of Charlie’s thoughts from their recent podcast:

“The world is full of foolish gamblers, and they will not do as well as the patient investor.”
~ Charlie Munger

“You have to keep learning if you want to become a great investor. When the world changes,
you must change.” ~ Charlie Munger

“If you don’t care whether you are rational or not, you won’t work on it. Then you will stay
irrational and get lousy results.” ~ Charlie Munger

I take these comments and apply them to the current market conditions. It’s very simple – be rational, stick to the long-term game plan, and tactically adjust where needed. If we are still unsure, we can always learn something from past markets. Current market conditions don’t need to mirror past market conditions to know that they always trade back to their long-term averages…and beyond.